No.
2060
August 7, 2007
The Estonian Economic Miracle
The Honorable Mart Laar
Estonia is a small country in Northern Europe on
the Baltic Sea, at the crossroads of East and West,
South and North. Samuel Huntington states that the
Estonian border is a border of Western civilization, a
border where civilizations clash.1 This has made Esto-
nia interesting to historians but hard for people who
live there.
Throughout history, Estonians have had to fight for
their freedom. In 1918, Estonia declared indepen-
dence. It was occupied by the Soviet Union in 1940
during the Second World War. We fought the commu-
nist terror during the war but were defeated. As a
result of the occupation, Estonia lost nearly 20 percent
of its population.
But we never gave up. When the 1980s offered us a
new chance, we took advantage of it. Estonia became
one of the first countries to pry open the cracks in the
Soviet Empire. Finally, in 1991, after 50 years of occu-
pation, Estonia became free again.
We had freedom but little else. Estonia was
destroyed during the period of communist rule. In
1939, Estonia’s living standards and way of life were
more or less the same as neighboring Finland’s. Then
Estonia lost its independence, but Finland, despite
losing territory and population, succeeded in keeping
its independence. Life under two different political
systems created a huge disparity in the development
of Finland and Estonia. People learned and worked
hard on both sides of the Finnish Bay, but only the
Finns seemed to prosper. After starting from the same
point, Finland’s gross domestic product (GDP)
Talking Points
• Fifty years of communist rule devastated
Estonia. In 1939, Estonia and Finland had
similar standards of living. In 1987, Finland’s
GDP per capita was $14,370, compared to
Estonia’s GDP per capita of about $2,000.
• After the collapse of the Soviet Union, Esto-
nia took advantage of a narrow window of
opportunity to radically reform its economy.
• Key reforms included establishing a sound
currency, balancing the budget, cutting sub-
sidies to state-owned companies, opening
the economy through property reform and
privatization and by eliminating trade barri-
ers, replacing the tax system with a simple
flat tax, and establishing the rule of law.
• Estonia’s reforms have yielded stunning
results. Poverty and inequality are decreas-
ing. Estonia has low unemployment and low
inflation, and living standards are improving
rapidly. The government’s budget is not only
balanced, but also running a strong surplus.
This paper, in its entirety, can be found at:
www.heritage.org/Research/WorldwideFreedom/bg2060.cfm
An Economic Freedom Project Report
Produced by the Center for International
Trade and Economics (CITE)
Published by The Heritage Foundation
214 Massachusetts Avenue, NE
Washington, DC 20002–4999
(202) 546-4400 • heritage.org
Nothing written here is to be construed as necessarily reflect-
ing the views of The Heritage Foundation or as an attempt
to aid or hinder the passage of any bill before Congress.
No. 2060
reached $14,370 per capita by 1987, while optimis-
tic calculations put Estonia’s GDP at only about
$2,000 per capita.1
At the same time, even opponents of commu-
nism often failed to see the real economic problems
stemming from the socialist way of thinking. People
overwhelmingly hoped that removing the commu-
nists from power and liberalizing the economy
would be enough to enable their country to quickly
reach the same living standards as in Western
Europe. Nobody actually understood how back-
ward and underdeveloped the communist econo-
mies really were. As a result, the return to the free
world was harder and more painful than anybody
could have predicted.
The Window of Opportunity
It was cold in Estonia in January 1992. The end of
communism had created real chaos in the country.
Shops were completely empty, and the Russian ruble
no longer had any value. Industrial production
declined in 1992 by more than 30 percent—more
than during the Great Depression of the 1930s. Real
wages fell by 45 percent, while overall price inflation
was running at more than 1,000 percent and fuel
prices had risen by more than 10,000 percent.
People stood in lines for hours to buy food.
Bread and milk products were rationed. Because
there was no gas for heat, the government planned
to evacuate much of the capital of Tallinn to the
countryside. The only “institution” in Estonia that
seemed to work was the informal market.
Estonia was absolutely dependent on Russia,
which accounted for 92 percent of Estonian inter-
national trade. Estonia had little that it could sell on
world markets. The Soviet command economy had
ruined Estonia’s environment, and the infrastruc-
ture was in catastrophic shape. For most foreign
experts, Estonia was just another “former Soviet
republic” with not much hope for a better future.
Nor did many Estonians themselves believe in
Estonia’s future. Seeing the chasm between reality in
Estonia and what Estonians understood as a more
normal life, people realized that small steps were
1. Samuel P. Huntington, The Clash of Civilizations and the Remaking of the World Order (New York: Touchstone, 1996), p. 158.
2. Leszek Balcerowicz, “Understanding Postcommunist Transitions,” Journal of Democracy, Vol. 5, No. 4 (October 1994).
page 2
August 7, 2007
not enough. Estonia needed to make a decisive,
giant leap across the abyss. At the same time, there
was no time to lose. Acting quickly was essential to
reforming a country from its roots. This was the
main reason why in September 1992, in the first
democratic elections since World War II, the Esto-
nian people elected those offering the most radical
break from the Soviet past and the most decisive
reform program.
Reform-minded governments are not given
much time to take the necessary steps. There are
limits to the trust that people place in their politi-
cians and the level of pain that they are prepared to
endure. Exceeding these limits can set off a serious
backlash against the reformers and their new pro-
posals. Lescek Balcerowicz, one of the architects of
Polish economic reform, stressed the importance of
“extraordinary politics,” meaning that a radical eco-
nomic program launched as quickly as possible
after the breakthrough has a much greater chance of
being accepted than either a delayed radical pro-
gram or a non-radical alternative that introduces
difficult measures gradually. In his own words, “Bit-
ter medicine is easier to take in one dose than in a
prolonged series of doses.”2
Balcerowicz’s theory is based on the assumption
that liberalization from foreign domination pro-
duces in a country a special state of mind and cor-
responding political opportunities. Hence, the
government has the possibility to make decisions
that would not be made under normal political and
economic circumstances.
In this sense, a crisis is not so much a crisis as an
opportunity. Even a short examination of Central
and Eastern European experiences shows no link
between the intensity of social discontent (e.g.,
demonstrations and strikes) and the type of eco-
nomic program pursued. In fact, delaying some
necessary decisions can cause serious backlashes
that would not have occurred if they were made at
the right time. In reform, timing is everything.
The right decisions made at the right time can
provide countries with advantages and guarantee
greater satisfaction of the electorate through more
No. 2060
rapid development. The right decisions made too
late are usually still the right decisions, but the
results are often not as successful.
However, that window of opportunity does not
last long. It quickly gives way to the more mun-
dane politics of contending parties and interest
groups, which is normal in established democra-
cies. Parties always search for an agenda, an ideo-
logical profile to take more care of the practical
interests of their voters. Radical decisions become
harder to push through, and the speed of reforms
naturally slows down.
Transition countries that do not take advantage
of the period of “extraordinary politics” to launch a
radical economic program still face the challenge of
making the transition to a market economy, but
under more difficult economic conditions. The
countries that miss this opportunity risk macroeco-
nomic instability, excessive and chaotic state regula-
tion, and massive corruption.
These countries are usually given a second
opportunity after the parties in power have totally
failed, but if they miss the second opportunity, it
becomes extremely difficult to convince the people,
who have suffered twice the pain with no benefits,
to go through it all once more.
If essential reforms must be accomplished in a
relatively short time, preparation time is also brief.
Laws that are passed must therefore be as simple as
possible, and the resources to implement any par-
ticular decision are inevitably limited. This limita-
tion also argues for simplicity, a fact repeatedly
mentioned by Anders Åslund in his studies of tran-
sition economies.3
Estonia tried to learn from all such experiences.
Two main lessons emerged from our own reform
process. One is to take care of politics first and then
to proceed with economic reform. The other is
summed up by the well-known advertising slogan:
“Just do it.” In other words, it is essential to be deci-
sive about adopting reforms and stick with them
despite the short-term pain that they cause.
3. Anders Åslund, “Possible Future Directions for Economies in Transition,” in Joan M. Nelson, Charles Tilly, and Lee Walker,
eds., Transforming Post-Communist Political Economies (Washington D.C.: National Academy Press, 1998), pp. 455–470, at
http://books.nap.edu/openbook.php?record_id=5852&page=453 (July 31, 2007).
August 7, 2007
We had to deal with politics first because to ini-
tiate and sustain radical reforms, we needed to form
a legitimate consensus for change. A consensus is
possible only through democracy, using regular,
accountable institutional structures and free and fair
elections. To be successful from that point forward
required a clear break with the totalitarian past and
with the structures and people representing it.
The First Steps: Monetary Reform
and Macro Stabilization
The beginning of economic reforms in Estonia
was similar to the experience of other Central and
Eastern European states (also known as “transition
economies”), but in some areas it was perhaps
worse. The Central European nations were able to
start reforms earlier, in 1989–1990, while Estonian
reforms began in 1991–1992. This loss of time was
crucial and allowed the Estonian economy to dete-
riorate further.
The first real reform in Estonia was monetary
reform in the summer of 1992. Introducing our own
currency was an important challenge for Estonia. In
the beginning, it seemed like a faraway dream. Sup-
porters of monetary reform suggested different paths
of reform, but all identified three objectives: elimi-
nating inflationary impacts from the east, guarantee-
ing an equilibrium exchange rate based on supply
and demand, and conquering the cash crisis.
Estonia launched its monetary reform in June
1992 by becoming the first country in the former
Soviet Union to introduce its own currency. Using a
currency board system, the Estonian kroon was
made fully convertible from the first day by pegging
it to the German mark. Fixing the exchange rate to
a strong currency like the Deutsche mark created
trust in the Estonian economy. However, to reap the
benefits of having a currency board, Estonia also
had to balance the budget. As a political slogan, bal-
ancing the budget was quite popular, but in practice
it was highly unpopular.
Whereas in many other Central and Eastern
European countries the initial “shock therapy” was
page 3
No. 2060
freeing prices to fluctuate, in Estonia it was balanc-
ing the budget in 1992. The priority placed on elim-
inating budget deficits was thus not only well
grounded in economic thought, but also, more
practically, the only way out of a desperate situation.
The developments in several other Central and
Eastern European countries indicated that mone-
tary reform cannot succeed unless the budget is
strictly controlled.
This became the task of the new government
elected in September 1992. The government led by
Pro Patria Union was built from groups and parties
that had been part of the resistance movement
against Soviet occupation and were therefore deci-
sive in breaking with the communist past. Members
of the government were very young. As the newly
elected Prime Minister of Estonia, I was 32 year old,
and many ministers were even younger. Like other
young people, we did not know what was possible
and what was not—so we did impossible things.
The buildup of a government action plan started
with the creation of a government coalition.
Launching a radical reform program would have
been impossible without a firm and stable majority
in the Riigikogu, the parliament of Estonia. The size
of the majority was not important—the Pro Patria
government had a majority of one vote. What is
important is that it works. For that to happen, all
members of the coalition must know their tasks and
the government’s agenda.
To achieve this, our major focus was the coalition
agreement, which not only assigned cabinet seats
among parties in the coalition, but also clearly pre-
sented the government’s action plan. Every member
of our coalition signed the agreement, which was
crucial to enacting the economic reforms in Estonia.
Even when the government’s decisions were furi-
ously attacked by the opposition, the government
had the necessary majority in the Riigikogu to pass
the necessary legislation.
Developing such a comprehensive program took
some weeks. In Estonia, this was done with the help
of several think tanks from abroad: The Heritage
Foundation, the International Republican Institute,
the Adam Smith Institute, and Timbro in Sweden.
Also vital were the first Estonian think tanks, cre-
ated years earlier by the same parties that had just
page 4
August 7, 2007
come to power. Most of the reform agenda was pre-
sented and discussed at events organized by these
think tanks, making the public familiar with the
details. Without these think tanks, the fast and
effective buildup of a government action plan
would probably not have been possible.
Being prepared, we had the opportunity to act
quickly and decisively. Balancing the budget
required radical cuts in all kinds of subsidies and
reducing the size of government. Each of these cuts
was unpopular. We pushed through these cuts
thanks to the coalition agreement, which established
balancing the budget as the most important goal.
We tried to include the opposition in the budget
discussions, but as in any other democratic country,
the opposition was not willing to cooperate and
instead actively fought the budget cuts, using both
parliamentary obstruction and street demonstra-
tions. In this situation, the government needed to
ensure that all its majority voted and did not waste
time on too many discussions. (Once, we had to
transport a member of parliament who had just
given birth from the hospital to parliament so that
she could vote on an important piece of legislation.)
Reforms must be pushed through, not piece by
piece, but in the biggest chunks possible. Political
resistance to both small and big reforms is the same.
We passed huge amounts of necessary laws within
some months and balanced the budget. Afterward,
we passed a law that only a balanced budget could
be presented to the Estonian parliament. This
requirement enabled the government to pass subse-
quent balanced budgets more easily and has made a
balanced budget one of the trademarks of Estonia.
Estonia set achieving macroeconomic stability as
its first primary objective. Monetary reform, the
strict restraint of a pegged currency, and the bal-
anced budget were all aimed at achieving that goal.
The stringent financial restraints made it easier for
the government to decide what to do. Without the
ability to print money or any other way to raise
money, the government could only balance the bud-
get by cutting expenses. The International Mone-
tary Fund (IMF) offered a loan to balance the
budget, but the government decided to build the
future of Estonia on the momentum for radical
reforms, not loans.
No. 2060
As part of this momentum, subsidies for state-
owned companies were identified as a poor policy,
and they were cut. This was important for the devel-
opment of new private companies because subsi-
dies preserve old and often outdated production
structures and hamper structural change in the
economy. Cutting subsidies sent the Soviet indus-
trial dinosaurs a simple and clear message: Start
working or die out. As was shown by subsequent
developments, the majority chose to start working.
It was important, therefore, that we were honest
with our partners and the public during the negoti-
ations on the coalition agreement. We said that the
first years of reform would be extremely difficult, so
the members of parliament who had to vote for
such measures knew what would happen. This
approach kept the government coalition together, at
least for a year and half.
Our government coalition understood that the
only way out was to continue along the path that we
had charted. Otherwise, the people would have
endured the suffering which inevitably accompa-
nies stabilization of the economy but would have
failed to see the results.
Estonia was confronted with an unavoidable
decline in living standards, industrial and agricul-
tural output, and GDP. Any movement toward pros-
perity therefore demanded the elimination of old,
inefficient, artificially supported economic activities
and the establishment of the “invisible hand” of the
market economy.
By 1993, we started to see the first real results of
these measures. The macroeconomic situation had
stabilized. The inflation rate had dropped signifi-
cantly, from 1,000 percent in 1992 to 89.8 percent
in 1993 and then to 29 percent in 1995. The econ-
omy was reoriented from the East to the West, and
exports had started growing rapidly. All of these
good signs gave us a great chance to move to the
second stage of reforms and put Estonia on the path
to real long-term growth.
Openness
The transition from the first stage of reform to
the second stage was one of the most decisive
moments for the reform process. In the first stage,
many of the government’s tasks were relatively easy
August 7, 2007
and largely determined by the realities of the exist-
ing difficult situation. In the second stage, both the
freedom to choose and the consequences of those
choices increased. In the first stage, a small team
could achieve macroeconomic stabilization by
implementing the reforms from the top down, but
success in the second stage required involving a
much broader group of people in the process,
touching their hearts and changing their attitudes.
The shock therapy of macroeconomic stabiliza-
tion gave the people a rude awakening. In the sec-
ond stage, it was necessary to give them new hope,
new prospects, and new opportunities. Without a
major readjustment of attitudes, the post-commu-
nist predicament would have become a trap, and
the nation would never have moved forward to
become a “normal” country with a free government
and free markets under the rule of law.
Under Soviet-imposed socialism, people were
not used to thinking for themselves, taking the ini-
tiative, or assuming risks. Many had to be shaken
free of the illusion—common in post-communist
countries—that somehow somebody else would
solve their problems for them. It was necessary to
energize people, to get them moving, and to force
them to make decisions and take responsibility for
themselves. The government declared that it could
only help those who were prepared to do something
for themselves. This principle proved unpopular,
but it helped to change attitudes.
To accomplish these goals, Estonia had to find a
way to give people different opportunities to do
business. To create that opportunity, we felt that we
had to open the economy to world markets. We
needed to foster competition and attract foreign
investment. Lots of people were afraid of such
openness, so the government had to show the way.
As a small, open economy, Estonia historically
had relied on trade. Openness provides many
advantages for a smooth and rapid transition to a
market economy. It provides a rational set of mar-
ket-determined processes for resource allocation,
introduces more competition, allows countries to
specialize according to their comparative advan-
tages, and lets the market rather than the govern-
ment pick the winners. A policy of openness also
establishes an environment of transparency, with
page 5
No. 2060
clear market-based signals for producers. This is
also favorable to the development of subcontracting
activities that take advantage of the transition coun-
try’s skilled but low-cost labor.
Accordingly, Estonia reduced trade tariffs and
non-tariff barriers and abolished all export restric-
tions, making the nation a free-trade zone. One rea-
son for creating a free-trade zone is that we found
that tariff protections primarily favored sectors that
are politically organized rather than those that are in
the most need.
This open trade policy proved to be highly
successful, boosting competition, reconstruction,
and growth. Openness brought to Estonia many
new companies, which opened new, export-orien-
tated factories. Of course, this policy provoked
furious opposition, demonstrations, and petitions
“to protect strategic parts of economy” or “defend
local producers.”
We did not pay much attention to such protests
and pushed reforms through as fast as we could.
Once the first results of openness were seen, revers-
ing the reforms became much more difficult. Open-
ness will always be politically unpopular, but
nobody wants to change a system that works.
For a transition economy like Estonia’s, attract-
ing foreign investment was a superior alternative to
borrowing from international institutions, such as
the World Bank and the IMF. First, by accepting
development aid, we would have run the risk of
maintaining the relative backwardness of our coun-
try. Development aid may consist of obsolete tech-
nology and obsolete advice, which no longer assists
modern countries. By using this assistance, coun-
tries in transition lose the opportunity to use their
backwardness as a springboard for development.
To put it bluntly, give us no aid, but more trade.
The opposition heavily criticized this decision, but
we paid little attention to this because the decision
was supported by the parliamentary majority. When
presenting such a decision to the people, stressing
their national pride, they understand it quite well.
Although interest in foreign investment is rela-
tively similar in all transition countries, the results
achieved differ enormously. Some countries try to
encourage foreign investors by offering all sorts of
page 6
August 7, 2007
enticements, such as tax exemptions, privileges,
and special rights. The alternative is to build a busi-
ness environment that favors both local domestic
investment and foreign investment without making
any distinction between them.
Estonia chose the latter path. At the beginning,
there was a lot of discussion about this approach,
but because we had written it into the coalition
agreement, it was done quickly. When the positive
results of this policy were seen within a few years,
nobody wanted to change it.
Passage of the law on the sale of land ensured
that all foreign investors could feel a greater sense of
security, and it also signaled that their property
rights would be protected. At the same time, all spe-
cial privileges for a few foreign investors were abol-
ished, encouraging all kinds of investment. Soon
after, during 1993–1994, Estonia went from an
almost unknown spot in the world for foreign inves-
tors to a mecca for them. The government’s system-
atic work to build a good reputation for Estonia in
the world also helped to boost foreign investment.
As a result, Estonia received more foreign invest-
ment per capita in the second half of the 1990s than
any other country in Central and Eastern Europe.
This large inflow of investment created new work-
ing places, reconstructed old factories, brought new
knowledge and technology, and made Estonia more
modern and competitive.
Yet to be truly successful in transition, a country
must open its markets not only to the world, but also
to its own people. Democracy and the buildup of
civil society must be supported. An important step in
this regard was the introduction of a social dialogue
or partnership. In practice, this meant initiating tri-
lateral negotiations among the state, employers, and
employees. During 1992 and 1993, the government
supported the transformation of the Soviet-type trade
unions into free trade unions. This created a dialogue
between the government and the trade unions that
averted larger protests and demonstrations, particu-
larly during the first painful period of reform.
During trilateral negotiations, the government
explained the Estonian situation to the other two
sides. It was important to concentrate the negotia-
tions on the most difficult problems, creating clear
No. 2060
priorities. For example, when we agreed that our
biggest common goal was fighting unemployment,
explaining what steps were needed became signifi-
cantly easier.
Trade unions understood that even though a
lot of working places would be lost during priva-
tization, privatization was the only way to escape
from the current situation. If the enterprises were
not privatized and reconstructed, all of the work-
ers in the enterprises would lose their jobs. As a
trade-off, the trade unions were given the possi-
bility of presenting their proposals to the Privati-
zation Agency on how many jobs must be
guaranteed in privatized enterprises as a condi-
tion for a privatization agreement. Most impor-
tant was to make clear to the trade unions that
they really had access to the government and to
establish a regular dialogue between the govern-
ment and the trade unions.
All of these steps gave a firm boost to the develop-
ment of a civil society in Estonia by helping to bring
on fundamental changes in mentality and attitudes.
The people became used to expressing individual
opinions and actively influencing decisions. They
understood that their future depended on their own
activity. It is important to support the development of
free media, even when they often become critical of
the reform government. Freedom of the press is an
essential part of modern society, without which soci-
ety cannot function. Establishing democracy at all
levels of society is crucial for successful transition.
Only then can one be sure that the results of transi-
tion will not be turned back at any moment.
The Rule of Law
Radical economic reforms cannot be imple-
mented without laws regulating the economic
space. Although the rule of law has been and still is
one of the pillars of modern Western civilization, its
importance was not readily understood in several
transition economies. Some believed that decisive
reforms could be implemented without supporting
laws by using only government decrees or simply
letting the old structures collapse without creating
new legislation and institutions.
In some transition countries, politicians regretta-
bly believed that a free-market economy could mag-
August 7, 2007
ically create wealth without clear laws or
government to enforce those laws. Often, they paid
insufficient attention to renewing and strengthen-
ing—not enlarging—the government.
However, good laws by themselves are not
enough. All developing economies need to build
effective institutions that move their new laws from
paper to practice. Formal legal systems place
judges, prosecutors, arbitrators, court functionar-
ies, and the private legal profession in the role of
primary interpreters and enforcers of laws. Devel-
oping and securing all of these systems is vitally
important for the reforms’ success, as is creating an
effective civil service.
The rule of law is especially important in fighting
corruption, one of the worst diseases of transition
economies. Corruption thrives when public officials
and private agents have much to gain and little to
lose from taking a bribe, which is precisely the situ-
ation that exists in most transition countries. Uncer-
tain or non-transparent rules, heavy regulation, and
pervasive controls give officials exceptional power,
many opportunities to seek bribes, and a wide
scope for appropriating public wealth.
The Estonian experience illustrates that the most
effective method of dealing with corruption and
organized crime is decisive implementation of mar-
ket economy reforms and the development of a civil
society and the rule of law.
Any reform that increases the competitiveness of
the economy will reduce incentives for corrupt
behavior. Reducing controls on foreign trade,
removing entry barriers to private industry, and
privatizing state companies in a way that ensures
competition supports the fight. If the rules are
transparent and clear, and if the state has no author-
ity to license businesses or restrict exports and
imports, there will be no opportunities to pay bribes
in those areas. Eliminating subsidies, “soft” loans,
and all other such privileges removes another
inducement for bribes.
Using such methods and policies, Estonia fought
and successfully reduced corruption and organized
crime. Opening the national economy to competition
and introducing real reforms is the best way to avoid
crony capitalism. It is important to give enough
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No. 2060
attention and resources to judicial reform, reform leg-
islation, police forces, and building an effective and
transparent administration, even though these areas
may not look so necessary in the first years of reform.
Estonia put these areas on the priority list of reforms
and became the least corrupt country among all tran-
sition countries, achieving a better score in the inter-
national corruption index than some long-standing
member states of the European Union.
Finally, special attention must be given to bank
reform. Banks are a most important part of the
economy. If organized crime takes control of them,
it can quickly take over the entire country. Money
laundering, dirty money, and all other nefarious
operations must be separated from the banking sys-
tem as soon as possible. Government must be
extremely vigilant and tough on this issue because
dirty money is always followed by dirty people.
Estonia eliminated all state banks and made very
clear demands of private banks. Banks were to com-
pete, and we did not hesitate to let them go bank-
rupt when necessary. As a result of this clear
attitude, Estonia has the most effective banks in the
Baltics and is less corrupt than other new EU mem-
ber states.
Property Reform
At the heart of economic transition is a shift to
private ownership. Without private ownership, the
transition to markets is destined to fail. There are
different ways to achieve a secure, free economy
with strong property rights: restitution of property
to former owners, privatization of existing state
assets, and the re-emergence of private businesses.
For reformers, the question is not how much to
privatize, but how and when to privatize.
Privatization is never actually popular. It does
not win votes. This means that privatization must
be implemented as quickly as possible. There is no
time for negotiations with the opposition, and they
will fight it anyway.
Property reform and privatization are especially
important because clearly defined property rights
are essential to all truly reforming economies. These
two reforms are a necessary precondition for a func-
tioning market and the only way to change the
behavior of people and businesses and encourage
page 8
August 7, 2007
them to begin making the most important structural
changes. Getting the economy on this road to
change, not maximization of revenues, is actually
the most important goal of privatization.
At the same time, it is important to clearly guar-
antee property rights and to create the necessary
legal conditions and institutions to make this hap-
pen. Property laws must leave no room for interpre-
tation. Accomplishing this goal, however, is not
easy because property relations are always one of
the most complicated parts of legislation. The situ-
ation is even more difficult because such laws must
be passed quickly to prevent old property relations
from contradicting new ones.
In Estonia, we passed the first laws on property
reform in early 1992, concentrating first on return-
ing property that had been confiscated or national-
ized by the communist rulers to the original, legal
owners. In cases in which directly returning prop-
erty was not possible, people received compensa-
tion, not in money but in the form of privatization
vouchers. With these vouchers, they could buy
minority shares of privatized companies or land.
When it was clear which property would to be given
back to the legal owners, all other property was
privatized. Land and housing were privatized using
vouchers that people had received previously,
quickly making as many people as possible owners
of private property.
This was a complicated process. Left-wing par-
ties protested furiously against such measures and
organized rallies against them, but we stayed firm
and accelerated the process. Once people have
become property owners, the process can be
reversed only by brute force. As in all other reforms,
speed is important in property reforms. At the same
time, it is necessary to pass the laws that guarantee
real protection of property rights, not only in theory
but in reality.
Larger objects were privatized by the Estonian
Privatisation Agency, Estonia’s Treuhand, in open
bids. In most cases, a majority share of each com-
pany was sold to one core owner, and minority
shares were sold to individuals for vouchers. This
guaranteed legitimate owners for companies while
ensuring that everybody could participate in the
privatization. The goal of privatization was to guar-
No. 2060 August 7, 2007

antee necessary investments and a minimum num- Chart 1 B 2060

ber of workers in privatized factories for a certain
time, not just to generate revenue for the govern-
ment. As a result of these policies, the privatization
process was smooth and fast, making Estonia a
country of property owners.
The Flat Tax
To achieve a lasting breakthrough in Estonia’s
development, it was essential to make the most of
the people’s energy. Accomplishing this goal
required both creating a favorable economic envi-
ronment for private enterprise and inspiring people
to assume responsibility for their own future.
While the second goal was attained largely
through shock therapy, achieving the first objective
was much more complicated. It was partly accom-
plished through adopting legislation based on liberal
or limited regulation of the economy, thus depriving
the bureaucracy of opportunities to intervene or eas-
ily undermine the foundation of new companies.
However, limiting regulation was not enough.
When people who had started their own companies
realized that the tax system punished success, their
enthusiasm to persevere and determine their own
future declined considerably. In this situation, they
were more ready to move from the traditional tax
system to a new and radical system.
Radical tax reforms are popular only while they
are part of theoretical discussion. When politicians
try to implement them, the reforms immediately
become highly unpopular. Winning elections on a
platform of tax reform is difficult, but once a gov-
ernment is in power and must give the economy a
boost, cutting tax rates is a good idea.
This step demands great political courage. Gov-
ernments that cut tax rates or move to the flat tax
are inevitably accused of supporting the rich, even
though nearly all such tax reforms result in the rich
paying a larger share of tax revenue than before.
This fear of being labeled a supporter of the rich is a
main reason why governments hesitate to introduce
tax reforms, even when they know that such tax
reforms are necessary. They are afraid of being badly
defeated in next election.
Making the right decision and enacting the right
policy are more important. I was certain that we must
Estonian State Revenues
Revenue (billions of kroon) Real GDP Growth*
25
3.9
5%
GDP Growth 4.3
20
0%
15 -2.0
10
–5%
5
-9.0
0 –10%
1993 1994 1995 1996
Personal Income Tax Total Revenue
* Estonian statistics for 1993–1994 are more optimistic, listing
GDP growth at –2.0% in 1993 and 0.1% in 1994.
Source: UNICEF, “A Decade of Transition,” Regional Monitoring
Report No. 8, 2001.
not punish people who are good at what they do. On
the contrary, we decided to give them the opportu-
nity to work more and to take control of their future.
We decided that the entire tax system should favor
savings and investments and encourage people to
create new wealth. The tax system in Estonia had to
be simple, inexpensive to apply, and transparent and
understandable to the taxpayers. The tax base should
be as broad as possible with a minimum number of
exemptions, minimizing incentives for tax avoidance
such as the underground economy. The tax rates had
to be low, encouraging the activity of people and cre-
ating more growth.
The best solution to all these goals was a flat-rate
personal income tax, and Estonia introduced such a
system on January 1, 1994.
The tax system became simpler and easier to
understand for both taxpayers and tax collectors.
Taxpayers could easily fill out their tax forms and
avoid overly complex calculations and bureaucracy.
Tax collectors could avoid a lot of unnecessary work
and concentrate on those who were not paying their
taxes at all.
As a result of these simplifications, the tax
administration started to work more effectively, and
tax compliance increased. The grey sector was badly
hit, and state tax revenues started to increase rap-
idly. (See Chart 1.)

page 9
No. 2060
The flat tax reform also supported a rapid
increase in economic activity. The Estonian people
saw that if they worked more, they could earn more
without the government punishing their success
through higher tax rates.
Attitudes changed surprisingly fast. Thousands
and thousands of new small and medium-size enter-
prises, restaurants, hotels, and shops were estab-
lished. In 1992, Estonia had about 2,000 enterprises.
By the end of 1994, the figure had ballooned to
70,000. Estonia had changed from the country of the
working class to a country of entrepreneurs. The
incentives to take charge of their own future helped
Estonians to avoid massive unemployment.
Even after the Pro Patria government was voted
out the year after tax reform, the flat taxed stayed. It
turned out to be so effective that nobody seriously
wanted to change it. Since 1994, Estonia has seen
all possible government coalitions, often of parties
that won elections by promising to abolish the flat-
rate tax. Yet the flat-rate income tax persists.
The Estonian experience with the flat-rate tax was
so successful that other countries—first Lithuania
and Latvia and then Russia in 2001—have copied it.
Ukraine and Georgia have also introduced a flat tax,
as did Slovakia in 2004 and Romania in 2005.
The flat-rate income tax has increased eco-
nomic activity everywhere, created new work-
places, and suppressed the gray economy.
Comparing the economic growth rates in Central
and Eastern European countries with flat-rate per-
sonal income taxes to the growth rates of econo-
mies in the same region with progressive income
taxation, we can see that countries with flat-rate
taxes grew faster on average.
Comparing Central and Eastern European
countries with flat rates (Estonia, Latvia, and
Lithuania) to the most similar countries (Slovenia,
Poland, Hungary, Slovakia, and the Czech Repub-
lic), we can see that the flat-tax countries grew
significantly faster both in the first years after
introduction of the flat tax and during the past
three years. (See Chart 2.)
4. The Gini coefficient is a measure of income distribution on a scale from 0 to 1, with 0 corresponding to perfect income
equality and 1 corresponding to perfect income inequality.
page 10
August 7, 2007
Chart 2 B 2060
Central and Eastern European Economic
Growth, by National Tax System
Average Annual GDP Growth
10%
Non-Flat Rate
5% Flat Rate
0%
1996–1998 2003–2005
Source: European Commission, Eurostat, updated July 14, 2007, at
epp.eurostat.ec.europa.eu/pls/portal/url/page/SHARED/PER_ECOFIN
(July 18, 2007).
The countries with flat-rate tax systems have
reduced the relative income gap (in GDP per capita)
with “Old Europe” much faster than other coun-
tries. Eurostat figures show that Estonian GDP per
capita was 34.8 percent of the European average in
1996. Hungary was 48.5 percent, and Poland was
42.1 percent. In 2007, per capita GDP is roughly 65
percent in Estonia, 64 percent in Hungary, and 52
percent in Poland. The average catch-up of the three
flat-tax countries is 25 percentage points, compared
to Central and Eastern European countries with
progressive taxes that experienced only a 14 per-
centage point catch-up.
The other clear difference between the flat-rate
and progressive-rate countries is that the flat-rate
countries’ revenues and budgets are in better
shape. Opponents often argue that the flat-rate
personal income tax is socially unjust because it
creates bigger inequalities in society than pro-
gressive taxation creates. This assertion is untrue,
as the Gini coefficient4 of income distribution has
often decreased in flat-rate countries and is often
lower than in progressive-rate countries. (See
Table 1.)
In Estonia, the main increase in the Gini coeffi-
cient took place in 1989–1993, reaching its peak in
1995 with 0.398. It decreased in subsequent years.
No. 2060
Table 1 B 2060
Central and Eastern Europe: Change
in Income Distribution, 1989–1997
Change in Gini Coefficient
*Lithuania 0.036
*Estonia 0.081
Poland 0.059
Czech Republic 0.041
Russia 0.123
Bulgaria 0.133
* Countries with a flat tax system at the time.
Sources: European Bank for Reconstruction and Development,
“Transition Report, Update 1995,” April 1995, and “Transition
Report, Update 1997,” April 1997.
The flat-rate tax increased budget revenues,
reduced incentives for the gray sector of the econ-
omy, and supported growth and economic activity.
With such positive results, the Estonian example is
now followed by more and more countries, pushing
all Europe nearer to a real tax revolution.
The Estonian Miracle
Radical reforms in the 15 years since 1992 have
changed Estonia beyond recognition from its com-
munist days.
It is sometimes hard for us to remember how this
country looked under the old system. Estonia
became the first former communist country to rise
to the status of a “free” economy in the annual Index
of Economic Freedom, published by The Heritage
Foundation and The Wall Street Journal. Even more
remarkable, it is not just a “free economy,” but one
of the freest in the world, ranking 12th in the 2007
Index of Economic Freedom.5
As a result of this amazing transformation, Esto-
nia has experienced the fastest economic growth in
Europe during the past few years. Since the start of
Estonia’s reforms, economic growth has averaged 6
percent per year. Growth was nearly 11 percent in
2005 and nearly 12 percent in the first half of 2006.
5. Tim Kane, Kim R. Holmes, and Mary Anastasia O’Grady, 2007 Index of Economic Freedom (Washington, D.C.: The Heritage
Foundation and Dow Jones & Company, Inc., 2007), at www.heritage.org/index.
August 7, 2007
As a result of this formidable growth, Estonia is
catching up to the average European living standard
faster than anybody expected.
Poverty and inequality are decreasing in Estonia.
According to the United Nations Human Develop-
ment Index, Estonia has moved from the group of
not-so-developed countries to the group of devel-
oped countries. Estonia has low unemployment and
low inflation, and living standards are improving
rapidly. The budget is not only balanced, but also
running a strong surplus. Estonia has passed several
social reforms, such as health care and pension
reform, and has become a full member of both
NATO and the European Union.
By nearly any standard, Estonia is the most com-
petitive economy among new EU member states.
Only 10 years ago, Estonia clearly lagged behind
most Central and Eastern European countries, but it
has since passed them and is fast approaching the
living standards of Old Europe.
All of these changes have allowed Estonia to pre-
pare for the new challenges of the 21st century. The
nation made a real jump in modern technology and
is a frontrunner in e-government. During cabinet
meetings, members of the government use only
computers—no paper at all. Estonia is now ahead of
many EU countries in Internet use. Estonians trans-
act a large part of their bank transfers through the
Internet. Tax declarations can be sent to the Tax
Department electronically—more then 70 of Esto-
nians did this in 2006. Best of all, completing the
tax form takes about five minutes.
E-government can be a very effective tool in cre-
ating a lean and open government. The govern-
ment’s use of the Internet has in turn created
favorable opportunities for new high-tech enter-
prises. Estonia has become the birthplace of many
such enterprises. The most famous Estonian inven-
tion is the Skype electronic communication system,
which was voted third most influential new trade-
mark in the world in 2006. Of course, there is still a
lot work to do. Estonia must face new challenges,
but that really depends on Estonians themselves:
The most difficult years are behind us.
page 11
No. 2060
Looking back on Estonia’s transition from misery
to prosperity, I can say from personal experience
that the prime minister’s task is not to be popular,
but to build a working coalition, have a clear pro-
gram of what to do, and then have the courage to
make the decisions.
In a democracy, no prime minister stays in
power forever, but a prime minister probably has
a better chance of returning to power or staying in
power when people can see that he really achieved
something. I am a living example of this. I am the
only prime minister in the transition countries
who was voted back into power after being
ousted, and I am the longest-serving prime minis-
ter in Estonian history.
Of course, implementing reforms can make a
government unpopular. Thus, governments that
implement such policies run the risk of being
page 12
August 7, 2007
ousted from power sooner rather than later, but
this is not important. Changing the country for
the positive beyond recognition is far more
important. Looking back, one can say: This was a
dirty job, but someone had to do it. Once set in
motion, the train cannot be easily stopped, and
this is actually the only thing that matters.
—The Honorable Mart Laar served as Prime
Minister of Estonia from 1992 to 1994 and from
1999 to 2002.
This is the third in a series of first-hand accounts
of how countries achieved notable economic success
by following the principles of economic freedom. Pre-
vious papers are: “How Ireland Became the Celtic
Tiger” (Backgrounder No. 1945) and “How Chile Suc-
cessfully Transformed Its Economy” (Backgrounder
No. 1958).